An interesting take on financial innovation

From VoxEU, Bruno Biais, Jean-Charles Rochet and Paul Woolley examine financial innovation. They argue that financial innovations have a potentially socially beneficial role but with asymmetric information between those who manage and those who consume the innovation, it carries the ‘seeds of its own destruction.’ The issue is that as an innovation looks like it is actually successful (say in providing liquidity of managing risk), managers need to be incentivized to continue monitoring performance. An example of this is investigating the risk profile of an instrument yourself versus relying on a rating agency. You want the manager to add effort in evaluating instruments but when those instruments look like they are having a good run, there is every incentive to shirk. So what you see is lots of financial success coupled with a disproportionately large increase in the returns to working in the financial sector than elsewhere. That is the one thing that is the sign that things have gone array. This means that policy-makers have to hit the information asymmetry problem head-on to improve matters. In the meantime, watch the size of the finance sector relative to the economy.

Interesting story on the upcoming campaign for a Tobin tax in Australia here: http://inside.org.au/will-robin-hood-ride-again/. A Tobin tax would presumably damp the more extreme “financial innovations” by reducing the size of the financial sector, limiting trend-following and making the level of leverage and arbitrage required unprofitable.

Apologies for the OT post, but I heard your colleague Sam Wylie on PM yesterday trying an argument from condescension against the Tobin Tax (or “Robin Hood tax” as it has been called), viz, “Tim Costello and Peter Singer are very fine people but they just don’t understand sophisticated financial economics” (the way I do).
Given that economists as distinguished as Paul Krugman and Joseph Stiglitz (both winners of the Riksbank prize in economics) and Dean Baker (one of the few to accurately call the US housing bubble and resultant crisis) advocate a Tobin Tax, and Sam lacks a Riksbank medal, will he accept that they understand more than he does and reverse his position?

Isn’t canceling out asymmetric information the purpose of having a rating agency, because it takes too much work to do the analysis oneself… but this is the first posting I’ve seen to reference VOX articles, so kudos to that.